Adverse Selection Costs and Closed-End Funds

Abstract

We examine the magnitude and the cross-sectional determinants of the adverse selection component of the spread for a sample of 266 closed-end funds traded on the New York Stock Exchange. We find no evidence that the adverse selection component of the spread for closed-end funds is related to portfolio turnover, the discount/premium to net asset value, the volatility of the discount or the expense ratio. However, we find a positive relation between blockholdings and the adverse selection component of the spread. We argue that uncertainty in the market about private benefits being paid to blockholders leads to these higher adverse selection costs. Unlike Neal and Wheatley (1998), we find that the adverse selection component is, on average, 50 percent lower for domestic and international equity closed-end funds than for a size and volume matched control firm. Finally, we find that the fund?s adverse selection component is significantly lower than the weighted average of the adverse selection components of the stocks in the fund's portfolio. These results are consistent with Gorton and Pennacchi (1993) and Subrahmanyam (1991) who suggest that combining individual securities into baskets may reduce the adverse selection costs of trading.